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Private Equity Firms Turn to Dividend Recaps To Bolster Liquidity

Michael Psaros loathes the idea of being a seller these days. The co-founder and managing partner of New York turnaround investor KPS Capital Partners says the traditional exit channels — that is, the selling of private equity deals — remain singularly unattractive. Even after a three-year slump, the sector shows few signs of a turnaround.

Michael Psaros loathes the idea of being a seller
these days. The co-founder and managing partner of New York
turnaround investor KPS Capital Partners says the traditional
exit channels — that is, the selling of private equity
deals — remain singularly unattractive. Even after a
three-year slump, the sector shows few signs of a
turnaround.

A number of KPS’s portfolio companies, such as
East Alton, Illinois–based Global Brass and Copper,
are well positioned to fetch a handsome price once the economy
comes back, he says. A few years back, KPS, which has $2.6
billion under management, created GBC from a carve-out of Olin
Corp.’s metals division for $400 million in cash.
Intent on getting a good price and gaining some liquidity,
Psaros, now 43, turned to a maneuver known as dividend
recapitalization.

Dividend recaps occur when a company takes on new debt to pay
out a special dividend to private investors or shareholders.
The upside is the payout; the downside is the high leveraged
debt, which increases the chance of bankruptcy.

In August, GBC issued $465 million of new debt, of which $102
million was used to issue a cash dividend to shareholders
— KPS is the majority shareholder and together with
company management holds 100 percent of GBC — and the
rest to refinance its outstanding debt. Earlier this year, GBC
issued a $100 million dividend funded directly from
GBC’s cash flow. With the two dividend
distributions, KPS has returned its equity investment plus a
tidy profit, says Psaros. "While we wait to sell our portfolio
companies, dividend recap is a great way to provide incremental
liquidity to our limited partners and our fund," he adds.
Psaros declined to provide specifics.

Dividend recaps have become a viable means of adding liquidity
as private equity firms face a prolonged dry spell. Blackstone
Group, Madison Dearborn Partners and D.E. Shaw & Co. are
among the many firms that have obtained liquidity through such
deals. In total, dividend recap volume rebounded to $10.5
billion during the first two quarters of 2010, compared with
$900 million in 2009 and $2.7 billion in 2008. To be sure,
dividend recaps kept many deals in motion, given that realized
exits for private equity firms during the first two quarters of
this year were just $48.6 billion, according to data tracker
Dealogic.

Compared with those done at the peak of the equity bubble,
today’s dividend recaps are tamed lions. Aside
from a number of deals leveraged at more than 5 times ebitda,
or earnings before interest, taxes, depreciation and
amortization — the most leveraged deal:
Blackstone’s AlliedBarton Security
Services’ $111.5 million recap done in August,
leveraged at 6.1 times — the vast majority of the 50
or so deals this year are modestly leveraged at below 5 times
ebitda. Moreover, most dividend recaps are financed by the bank
loan market, with strict covenants, rather than the loosely
structured pay-in-kind notes used three years ago. "Deals are
done at a leverage ratio that makes more sense," says Rod
Miller, a partner at New York–based law firm Weil,
Gotshal & Manges, who has worked on more than a dozen
dividend recap deals in his 17-year career. "Since most of this
recent batch of deals has been financed with first lien bank
debt, private equity owners have to make calculated decisions
to balance the risk and their liquidity needs."

In comparison, private equity firms were able to
claw back their investments through dividend recaps much faster
during the boom. Many of those companies ended up dangerously
leveraged at 7 to 8 times ebitda after recap deals, and some
didn’t survive.

There’s no doubt dividend recaps increase the
chances of restructuring, says Weil’s Miller. But
KPS’s Psaros argues that appropriately leveraging
companies — many of which KPS salvaged from bankruptcy
with zero or little debt — shields the companies from
huge tax bills. Philip Canfield, principal at GTCR Golder
Rauner in Chicago, an $8 billion-in-assets private equity firm,
agrees. "When there has been significant value creation in a
company," he says, "dividend recaps can be ideal to leverage it
up to an appropriate level." GTCR, it should be noted,
hasn’t done a dividend recap deal in the past
three years. None of the firm’s portfolio
companies are sufficiently "mature and seasoned," says
Canfield. Wise words.